Dollar drops broadly on cheaper swap lines

China cuts its reserve requirement ratio for banks

By

WilliamL. Watts

NEW YORK (MarketWatch) — The U.S. dollar dropped against the euro and other major currencies on Wednesday, though it pared losses as the session wore on, after the world’s major central banks moved to cut borrowing costs for banks and strengthen existing swap lines.

The euro
EURUSD, +0.2522%
jumped to $1.3446, after being flat before the announcement versus $1.3329 in North American trade late Tuesday. It touched $1.3532, its highest level in about two weeks.

The dollar index
DXY, -0.24%
which measures the U.S. unit against a basket of six major currencies, dropped to 78.345, from 78.990 Tuesday.

Against the Japanese yen, the dollar
USDJPY, +0.11%
fell to 77.53 yen from ¥77.85 Tuesday.

U.S. Federal Reserve, the European Central Bank, the Bank of England, the Bank of Japan, the Bank of Canada and the Swiss National Bank extended existing swap lines for banks to borrow dollars and lowered the cost of using them to ease strains in financial markets. In recent days, the cost of swapping euros for dollars via implied one-month cross-currency basis swaps rose to its highest level in three years. Read story on central bank swap lines.

The problem has been that traders have been attaching a stigma to banks that have to access central bank funding, making firms reluctant to use the option even though it’s been cheaper than the market-based rates, said David Watt, senior currency strategist at RBC Capital Markets. See what’s expected next from the Fed.

Central banks are “hoping the rate is so attractive that hitting the swap line makes business sense as opposed to signalling vulnerability,” he said. “They hope if they draw enough institutions, the stigma will decline, stresses on the liquidity front will ease and that will ease some of the bearish demeanor towards the euro.”

More than real optimism that Europe’s problems have been solved, the big swing in markets is in large part due to traders having to reverse bets against the euro and other risk assets, said Tommy Molloy, chief dealer at FX Solutions.

“The price action was because the market was short, not being bought by people entering new long positions in euros and equities,” he said. “It’s people closing shorts.”

China’s reserve rate cut

“This morning’s coordinated action also implies that the central banks feel conditions are much worse than they would otherwise lead us to believe, which is why more liquidity is needed immediately,” said Kathy Lien, director of currency research at GFT. “The markets are always relieved to see central banks put up a unified front, especially on the heels of a similar increase in liquidity from China.”

But strategists said Europe’s sovereign debt problems will continue to be the key driver for the euro.

The influx of liquidity “does not remove the need for structural reforms and more commitment from European nations but it eases conditions in the financial markets and shows that central banks are willing to work together to avoid another financial catastrophe,” Lien said.

At the end of a meeting in Brussels Tuesday, the finance ministers from the 17 euro-member countries meeting approved the release of Europe’s portion of Greece’s 8 billion euro ($10.7 billion) aid tranche, as markets expected.

They also agreed on a plan to leverage the funds of the €440 billion European Financial Stability Facility, or EFSF, to give the bailout fund more firepower and said it would be operational by mid-January. See more on EFSF.

“The problem ... is that the market sees [the enhanced EFSF] as DOA [dead on arrival],” said Steven Barrow, currency strategist at Standard Bank. “Foreign sovereign wealth funds have not shown much interest in contributing to the fund.”

The euro had also gained a little ground following reports saying China’s central bank cut the reserve requirement ratio for its banks by 50 basis points, the first reduction in nearly three years. The cut marks a swing to easier monetary policy amid rising global market turmoil. Read more on China bank-reserve cut.

For the month, the euro has lost about 3%, though it managed a 0.4% gain for the year.

The dollar index is up 2.9% in November, but has lost 0.9% so far in 2011.

Against the yen, the dollar is off 0.3%. For the year, it’s lost 4.5%.

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